Steve Hamilton is a Tampa native and a graduate of the University of South Florida and the University of Missouri. He now lives in northern Kentucky. A career CPA, Steve has extensive experience involving all aspects of tax practice, including sophisticated income tax planning and handling of tax controversy matters for closely-held businesses and high-income individuals.

Friday, July 28, 2017

RERI-ng Its Ugly Head - Part One

Here is the
Court:

The action involves RERI Holdings I, LLC (RERI). On its 2003
income tax return RERI reported a charitable contribution of property worth
$33,019,000. Respondent determined that RERI overstated the value of the
contribution by $29,119,000.”

That is considerably
more than a rounding error.

The story
involves California real estate, a billionaire and a university perhaps a bit
too eager to receive a donation.

The story is
confusing, so let’s use a dateline as a guide.

February 6,
2002

Hawthorne bought California real
estate for $42,350,000. Technically, that real estate is in an LLC named RS Hawthorne
LLC (Hawthorne), which in turn is owned by RS Hawthorne Holdings LLC
(Holdings).

Holdings in turn is owned by Red Sea Tech I (Red Sea).

February 7,
2002

Red Sea created two types of
ownership:

First, ownership for a period of time (technically a “term of
years,” abbreviated TOYS).

Second, a future and successor interest that would not even
come into existence until 2021. Let’s call this a “successor” member interest,
or SMI.

QUESTION:Why a delayed ownership interest? There was a great lease on the
California real estate, and 2021 had significance under that lease.

March 4,
2002

RERI was formed.

March 25,
2002

RERI bought the SMI for $2,950,000.

August 27,
2003

RERI donated the SMI to the
University of Michigan.

A key player here is Stephen Ross, a billionaire and the principal
investor in RERI. He had pledged to donate $5 million to the University of
Michigan.

Ross had RERI donate the SMI.

The University agreed to hold the SMI for two years, at least,
before selling.

Do you see
what they have done? Start with a valuable piece of leased real estate, stick
it in an LLC owned by another LLC owned by another … ad nauseum, then create an
LLC ownership stake that does not even exist (if it will ever exist) until 2021.

What did
RERI donate to the University of Michigan?

You got it: the
thing that doesn’t exist for 18 years.

I find this
hard to swallow.

“Successor”
LLC interests are sasquatches. You can spend a career and never see one. The
concept of “successor” makes sense in a trust context (where they are called
“remaindermen”), but not in a LLC context. This is a Mary Shelly fabrication by
the attorneys.

So why do
it?

Technically,
the SMI will someday own real estate, and that real estate is not worth zero.

RERI hired a
valuation expert who determined it was worth almost $33 million. This expert
argued that the lease on the property – and its reliable series of payments –
allowed him to use certain IRS actuarial tables in arriving at fair market
value (the approximately $33 million).

Wait. It
gets better.

The two
years pass. The University sells the property … to an entity INDIRECTLY OWNED
by Mr. Ross for $1,940,000.

This entity
was named HRK Real Estate Holdings, LLC (HRK).

More.

HRK had
already prearranged to sell the SMI to someone else for $3 million.

Still more.

That someone
donated the same SMI and claimed yet another deduction of $29,930,000.

REALITY CHECK: This thing sells twice for a total of
approximately $5 million but generates tax deductions of approximately $63
million.

Yet more.

Who did the
valuation on that second donation? Yep, the same guy who did RERI’s valuation.

The IRS
disallowed RERI’s donation to zero, zip, zilch, nada. The IRS was clear: this
thing is a sham.

And there
begins the litigation.

How
something can simultaneously be worth $33 million and $2 million?

This is all
about those IRS tables.

Generally
speaking, the contribution of property is at fair market value, usually
described as the price arrived at between independent buyers and sellers,
neither under compulsion to sell or buy and both informed of all relevant
facts.

Except …

For
annuities, life estates, remainders, reversions, terms of years and similar
partial interests in property. They are not full interests so they then have to
be carved-out and adjusted to present value using IRS-provided tables.

OBSERVATION: Right there, folks, is why the attorneys created
this Frankenstein. They needed to “separate” the interests so they could get to
the tables.

RERI argued
that it could value that real estate 18 years out and use the tables. Since the
tables are concerned only with interest rates and years, the hard lifting is
done before one gets to them.

Not so fast,
said the IRS.

That real
estate is in an LLC, so it is the LLC that has to be valued. There are numerous cases where the value of
an asset and the value of an ownership interest in the entity owning said asset
can be different – sometimes substantially so. You cannot use the tables
because you started with the wrong asset.

But the LLC
is nothing but real estate, so we are back where we started, countered RERI.

Not quite,
said the IRS. The SMI doesn’t even exist for 18 years. What if the term owner
mortgages the property, or sells it, or mismanages it? That SMI could be near
worthless by the time some profligate or incompetent is done with the
underlying lease.

Nonsense,
said RERI. There are contracts in place to prohibit this.

How pray
tell is this “prohibited?” asked the IRS.

Someone has
to compensate the SMI for damages, explained RERI.

“Compensate”
how? persisted the IRS.

The term
owner would forfeit ownership and the SMI would become an immediate owner,
clarified RERI.

So you are
making the owner of a wrecked car “whole” by giving him/her the wrecked car as
recompense, analogized the IRS. Can the SMI at least sue for any unrecovered losses?

Uhhhh … no,
not really, answered RERI. But it doesn’t matter: the odds of this happening
are so remote as to not warrant consideration.

And so it
drones on. The case goes into the weeds.

Who won: the
government or the billionaire?

It was
decided in a later case. We will talk about it in a second post.

About Me

Thirty years years in tax practice. It's a long time, and I have seen virtually everything short of the fabled tax-exempt unicorn. I was raised in Tampa, went to school in Missouri, taught at Eastern Kentucky University, lived in Georgia, got pulled to Cincinnati when I married, have in-laws in England and a daughter going to the University of Tennessee. I am not sure where I will wind up next, but I hope there is better weather.